Q: What is the history of the fund?
We have been involved in the fixed income market since the early 1990s. We both started our investment careers with GE when it owned GE Capital. Jim and I got our start in the fixed income investment area there, and that’s where we developed our general philosophy toward investing in fixed income. Under the constraints of a public entity, you do not want to generate losses; you want to have profitable, sound investments that generate a nice return over time. So we focused on those risk-adjusted returns.
We started this fund for Rainier Investment Management in 2009—right in the middle of the financial crisis—and Jim and I have been running it since April 1, 2009. After I spent roughly 18 months at Washington Mutual building a corporate credit team and investing approximately $3 billion, the financial crisis began, and I accepted an opportunity to come to Rainier as the Director of Fixed Income Investments and to start this fund. Angel Oak Capital, two of whose founding partners I had worked with at Washington Mutual, acquired the fund in April 2016.
Q: What is your investment philosophy?
We believe that if we focus on superior risk-adjusted returns over the long term, we should outperform in down markets and in up markets. And that should lead to long-term outperformance.
It is a very flexible, relative-value-driven process. We designed the fund from the very beginning to invest in a broad array of high yielding assets, not just your typical plain-vanilla high yield corporate bonds. It also might include collateralized loan obligations, bank loans, preferred stocks, converts, and even equities. It comes back to constructing a portfolio of high-quality issuers that we choose through the intensive fundamental research.
Our core belief is that we can take the appropriate amount of risk, make sure we get compensated for that risk, and then rotate the risk profile of the portfolio depending on valuations and expectations to protect our returns in down markets and enhance our risk-adjusted returns. When liquidity evaporates in down markets, corporate bonds can gap lower relatively quickly, which erodes the returns. We try constantly to gradually transition the risk profile of the fund in order to avoid or minimize those negative events.
For every investment we make, we look at credit first, then the structure of the investment, and then the price. We talk about relative value, but first we need to like the fundamentals of the company and the structure of the security. Only then does the price determine whether or not we put it in the fund.
We look first at the credit. We consider the strengths and weaknesses, the management, the credit profile, and where we think it could go from here. Jim and I need to be on the same page in terms of whether we like what we see. Free cash flow is probably our number one metric; we definitely focus on that. But if we like an investment’s potential for credit profile improvement, we might compensate for the current lack of free cash flow by looking at its structure—whether we can take a secured position in the capital structure or something of that nature.
Management is another critical component. We need to have a strong belief that management will do the right thing for all investors in the company, including fixed income investors. We definitely consider how management treats bondholders versus shareholders, and avoid companies that traditionally disadvantage bondholders in favor of shareholders.
Q: Do you avoid or gravitate toward any particular segments of the market?
We consider ourselves a higher-quality manager, not by the fund’s rating profile, but by the quality of the companies in it, the percentage of them that generate free cash flow, the financials, the quality of their management. But our profile is heavily single-B-rated bonds, the fund’s predominant rating, and then double B. As a practice, we cap our triple-C rating at about 10%, based on what’s going on in the market at the time and where we see an opportunity to use that bucket. We may go above that every once in a while—a downgrade may take us above that, for example—but only temporarily. Over time we rotate that down to low single digits when we do not feel we are being compensated for taking on the risk associated with more leveraged entities and issuers.
Q: What is your investment strategy?
We are heavily fundamentals-based, but obviously a lot of macroeconomic thinking goes into our strategy as well. Jim and I are the core of the high yield corporate credit team, but we are in constant communication with the entire portfolio management team at Angel Oak. We all have a daily call to talk about current events and the macro environment. One day a week is dedicated to highlights or an update on each asset class in which Angel Oak invests, including high yield and collateralized loan obligations, for example.
Jim and I constantly talk about what is going on in the economy, how central bank monetary policies might affect the economy at the margin, and what the fiscal policy is and how that might affect the different sectors of the economy, as well as looking at the global perspective on commodity prices, energy prices, things along those lines. So we do have a top-down perspective.
But we spend the majority of our time on the bottom-up perspective, focusing on the fundamentals at the individual companies, and where they are within their competitive landscape, their pricing power, and whether they are on a sustainable improving trend or have the competitive advantages to extract higher margins and improve their credit profile over time with higher cash flow and free cash flow.
We benchmark against the Bank of America Merrill Lynch U.S. High Yield Index, but we do not look like the index. We are definitely an active manager. We have significant overweights and underweights to the various sectors, driven by the research Jim and I do.
Q: Where does the investment process start?
The process starts with idea generation. We are constantly evaluating the market—the primary market with new issuance activity, secondary market opportunities, event-driven ideas, mergers and acquisitions, anything that might have potential to contribute to outperformance over the long term. We also regularly quantitatively screen the market for ideas, looking for outliers from a quantitative perspective, such as rating versus price and yield and spread within a sector or across sectors, to generate ideas.
There is also the qualitative aspect. We generate ideas among ourselves, across the team, about areas on which to focus. We narrow those ideas down and choose a few that we think have potential, and those enter the research and analysis process.
So it is really a four-stage process comprising idea generation, research and analysis, portfolio construction and execution, and finally monitoring and risk management of the investment strategy and the portfolio. Jim and I spend the majority of our time on the second part, the research and analysis.
We look for credit, structure, and price; an opportunity first has to meet the credit requirement, then have the right structure, and then have an attractive price. We look at the financials for each of the companies ourselves, and do all our own calculations. Using a Porter-type analysis, we assess the strengths and weaknesses, opportunities and threats, etc. We calculate the ratios in the way we like to see them, which is a little more conservative. We try to minimize the amount of adjustments that make them look more attractive than they should be.
We also focus heavily on the fundamental aspects of liquidity, because that is a focal point of the markets post-crisis. We look at the cash they have on hand. We consider their credit facilities and the structure of those facilities, and whether they can access them in a crisis. Then we look at their debt maturity profile, their need to refinance debt on an ongoing basis, and whether they can withstand a period of closed market access without putting debt investors at risk.
We are very focused on the qualitative aspect of the fundamental analysis, in other words, and that really centers on management. We have been doing this for over 20 years; we have known a lot of these companies and their management teams for many years. But with new issuers or new companies we definitely do not jump right in and believe everything they tell us. It takes time for us to get to know management teams, and to trust that they are going to do what they say they are going to do in the interests of all stakeholders, including fixed-income stakeholders.
We also look at the relative value metrics, valuation within the industry or sector and among their peers, and also across other sectors and within the current investment portfolio. We want to make sure we understand all the risks we are taking, that they are rational risks, and that we are being rewarded for taking them.
For us, part of understanding and evaluating management comes from being on every earnings call of every company we own. We never rely on transcripts or third-party research. There have been occasions when we will get off the call and say, “Hey, this just does not sound right,” or notice a change in management or in management philosophy. We have executed trades within minutes of getting off a call.
Jim and I share all responsibilities for evaluating and managing the portfolio, research, and trading. We are in constant communication about every issue in the portfolio, and we can make decisions and act quickly to protect performance and benefit our investors. Having that very flat structure allows us to be nimble.
Q: How would you describe your portfolio construction process?
We have a diversified portfolio with a broad array of issuers across most sectors and industries. But we do have significant overweights. Our target is to have 70 to 90 issuers within our liquidity constraints. This is the other aspect of liquidity we consider; we cap the size on an absolute level of exposure in the portfolio so that we can trade any security without negatively impacting the price in the market. We also cap individual exposure to any issuer at about 5%, and, as we mentioned before, we unofficially keep the triple-C exposure to 10%.
We do also employ sell criteria. If something happens that is unexpected versus our expectations—from a valuation standpoint, or an operative strategic standpoint, or a financial standpoint—we immediately consider selling. Also, when things reach full valuation based on our expectations, they are obviously sell candidates to make room for new ideas that we think might better enhance the portfolio’s performance.
We are also very focused on execution. We are in constant contact with the markets, with all the dealers. We employ several electronic trading platforms so we can take advantage of liquidity in trading opportunities wherever they may be, especially in this environment, where liquidity is a concern. We want to have as much access to potential sources of liquidity as we can.
Then it really comes back to the risk-control aspect, to continually monitoring these companies. We are on all the earnings calls for every company, and we monitor companies using various news sources and our other portfolio and trading tools to ensure we know what risks we are taking relative to our benchmark and are being compensated for them.
Q: Do you have any other limits besides position size?
No. We do not cap our sector exposure. Theoretically we could be 100% in any sector. But even though we are not an index fund, we are aware of the underweights and the overweights. We are conscious of what they are, why they are there, how they got that way, and whether we want to adjust them.
Q: What goes into your due diligence process for evaluating a security?
We put together a spreadsheet with the issuer’s financials and all the ratio calculations based on the inputs from the SEC filings and the quarterlies. Then we put together a document that identifies the strengths and weaknesses of the issuer, the industry, and the management.
It includes the conference call notes, so either one of us can quickly pull those up and see what the other was thinking about on the last call, the SEC filings and the filings for the prospectuses, our internal monitoring spreadsheet where we do all the quantitative analysis, our thoughts on the qualitative strengths and weaknesses, the earnings, recent performance from an operations standpoint, and the sell criteria. The document is on a shared drive that is accessible to anybody in the company.
Q: Do you rate every bond?
We do not have an internal rating system. Our approach is to determine what the value should be based on the outcome of our analysis in the context of all the other companies we are looking at: “This is trading at 7%, and we think that offers value relative to this other company we have in the portfolio that is trading at 6%. The credit profile is this, the market position is this.” We consider ratings a confirmation or a way to categorize the portfolio, but not really a driver of our investment decision.
We focus on the ratings when we think the market is becoming fully valued or overvalued. When everyone in the market is taking on additional risk in an attempt to outperform and the triple-C portion of the market looks rich, we factor that into our portfolio positioning. Because the tendency of investors is to sell the “riskiest credits” first, if everyone attempts to sell simultaneously, these are likely to get hurt just because of their rating.
Just because Moody’s calls something a ”double-B” does not mean that we think it is double-B risk. At some point you have to have a reference to put things into the different categories, but in our opinion the agencies sometimes underrate or overrate things. As a single-B-oriented fund, we consider ourselves a higher-quality high yield fund.
Hopefully, when you look at our performance track record, our upside and downside, and the volatility of the fund, it really gets back to our ability to identify quality companies irrespective of their ratings.
Q: How do you define and manage risk?
We like to think that risk management is part of the ongoing process. We obviously have our parameters in terms of sell discipline, exposure limits on individual issuers, and cap on triple Cs. Mainly we look at risk in the context of risk and reward: We are constantly aware of the risk we take, and we make sure we are being compensated for the risk in each opportunity.
Fixed income is a very asymmetric investment asset class, and so it is inherent in our belief that as valuations become full, based on the relative value tools that we use—as we monitor the valuation within high yield, within sectors and rating categories, as well as high yield versus collateralized loan obligations, or high yield versus investment grade, or high yield versus triple B-,—we need to transition the return profile of the fund appropriately.
So we manage the portfolio by looking at the historical spreads. We monitor the standard deviations on a regular basis to identify when things look rich or whether there are other sectors that offer better investment opportunities. When those things start to get to one standard deviation tight versus their historical means or below—whether that is within high yield, triple Cs versus double Bs, triple Cs versus single Bs, high yield versus investment grade, or high yield versus collateralized loan obligations—we start to reduce the risk profile in the portfolio. We say, “Here is the economy, here is the top-down within this environment, what do we think are the most risky, the most overvalued, the best combination,” and then we start to reduce that risk in the portfolio.
Then, when things are going the other way, when things look cheap by two or three standard deviations, we look at the companies we like and where they are trading cheap in the context of their industries and their peer group based on those relative value calculations that Jim and I do on a regular basis.
